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What, interest rates can go below zero?!

Ever since the financial crisis the world has seen record low interest rates that have prevailed far longer than most anyone expected. And, just when we’ve finally gotten used to this idea the central banks of several countries have begun adopting a Negative Interest Rate Policy (NIRP).

First, what is NIRP? It’s an up-until-now unconventional monetary policy tool whereby interest rates are set with a negative value, below the theoretical lower bound of zero percent. Economic theory tells us that during deflationary periods, or periods of very low inflation, people and businesses tend to hoard money instead of spending and investing. The result is decreased demand for goods and services which can lead to prices falling even farther, a slowdown in goods being produced and an increase in unemployment. An easy or expansionary monetary policy can be implemented to deal with such economic conditions. However, if deflationary forces are strong enough, simply cutting a central bank’s interest rate to zero may not be sufficient to stimulate borrowing and lending.

I was recently in San Francisco and had the privilege of attending a meeting where a former member of the Federal Open Market Committee was explaining that zero is merely a theoretical lower limit and that ‘the math still works’ when you go to negative rates. His point being, that theoretically, targeting interest rates below zero will reduce the costs to borrow for companies and households, driving demand for loans and incentivizing investment and spending.

But like most policies there are unintended consequences. With NIRP, the first is a de facto tax on savers and investors. Another is that many lending agreements, established years ago, never anticipated negative rates and are tied to certain indices. For the first time some loan agreements can actually come up with a negative rate whereby (in theory) the bank would be paying the borrower. The few instances I am aware of where this has occurred are being actively negotiated.

Last week Germany issued a 10-year bond at a negative .05%. This means that if you buy the bond for $1 you will receive no interest for ten years and get 99.5 cents when it matures. This does help explain why a 10-year U.S Treasury is attractive at 1.60% to foreign investors on a relative basis.

NIRP has not been around long enough to tell if it will ultimately work. In our opinion we do not believe that the United States is likely to see negative interest rates. Our economy is still solid and growing and we feel the Fed’s next action will be to increase interest rates rather than lower them.